<PAGE>   1

                                                                   EXHIBIT 13.1



                               CAERE CORPORATION
                               1998 ANNUAL REPORT

Financial Highlights



<TABLE>
<CAPTION>
                                                         Years ended December 31,
                                          -------------------------------------------------------
                                           1998        1997        1996        1995        1994
                                          -------     -------     -------     -------     -------
                                                    (In thousands, except per share data)
<S>                                       <C>         <C>         <C>         <C>         <C>    
Statement of Earnings data:
 Net revenues                             $65,802     $55,018     $54,528     $51,939     $59,130
 Earnings before income taxes              13,701       4,017         496       2,820       3,984
 Net earnings                              10,276       3,140         396       2,397       2,384
 Basic earnings per share                 $   .81     $   .24     $   .03     $   .18     $   .18
 Diluted earnings per share               $   .78     $   .24     $   .03     $   .18     $   .18

 Weighted average shares outstanding:
      Basic                                12,687      13,123      13,120      13,172      12,649
      Diluted                              13,246      13,265      13,319      13,538      13,136
</TABLE>


<TABLE>
<CAPTION>
                                                             As of December 31,
                                          -------------------------------------------------------
                                            1998        1997       1996        1995         1994
                                          -------     -------     -------     -------     -------
<S>                                       <C>         <C>         <C>         <C>         <C>    
Balance Sheet data:
 Cash and short-term investments          $44,337     $49,573     $44,290     $47,765     $51,099
 Working capital                           49,290      54,893      49,793      52,650      53,729
 Total assets                              63,884      67,300      63,154      69,298      67,902
 Total stockholders' equity                56,173      61,209      55,748      62,028      57,753
</TABLE>


Management's Discussion and Analysis of Financial Condition and Results of
Operations

Overview

The statements contained in Management's Discussion and Analysis of Financial
Condition and Results of Operations, and elsewhere in this annual report,
include "forward looking" statements and are subject to risks and uncertainties.
These statements discuss, among other things, expected growth, future revenues,
and future performance. The actual future results of Caere Corporation (the
"Company") could differ materially from anticipated results described in these
forward looking statements. Some factors that could cause future actual results
to differ materially from the Company's recent results or those described in the
forward looking statements include those listed below in the sections entitled
"Results of Operations," "Certain Trends, Issues, and Uncertainties," "Financial
Condition," and other statements set forth below, as well as the section
entitled "Risk Factors" in the Company's report on Form 10-K for its fiscal year
ended December 31, 1998. The Company assumes no obligation to update the forward
looking statements or such factors.


<PAGE>   2

Results of Operations

The following table presents, for the periods indicated, the percentage
relationship certain items in the Consolidated Statements of Earnings bear to
net revenues:


<TABLE>
<CAPTION>
                                               Percentage of net revenues               
                                            ---------------------------------            Percentage change   
                                                  Year ended December 31,             -----------------------
                                            ---------------------------------           1997           1996
                                            1998           1997          1996         to 1998         to 1997
                                            ----           ----          ----         -------         -------
<S>                                        <C>           <C>            <C>          <C>             <C>
Net revenues                                 100%          100%          100%            20%             1%

Cost of revenues                              21            26            30             (1)           (13)
                                             ---           ---           ---            ---            ---

                                              79            74            70             27              7
                                             ---           ---           ---            ---            ---

Research and development                      19            17            13             33             33
Selling, general and administrative           43            49            48              5              3
In-process research and development           --             5             8           (100)           (33)
                                             ---           ---           ---            ---            ---

   Operating earnings                         17             3             1            631            261

Interest income, net                           4             4             5              5             (7)
Writedown of investment in ZyLAB
   International                              --            --            (5)            --           (100)
                                             ---           ---           ---            ---            ---

   Earnings before income taxes               21             7             1            241            710

Income tax expense                             5             1            --            291            777
                                             ---           ---           ---            ---            ---

    Net earnings                              16%            6%            1%           227%           693%
                                             ===           ===           ===            ===            ===
</TABLE>


Under Caere's "bundle and upgrade" strategy, very low priced, limited-featured
optical character recognition (OCR) and in certain cases document management,
software products are bundled with products sold by certain scanner manufacturer
partners. When customers purchase scanners from these manufacturers, they will
be exposed to the utility and benefit of the Company's OCR and document
management technology. The objective of this strategy is to capitalize on such
exposure by getting a number of customers to "upgrade" from the bundled limited
edition version software to the Company's more fully-featured products.

Net Revenues

The following chart summarizes net revenues, cost of revenues, and gross margins
for the Company's products categorized between software and hardware. Software
product revenues are primarily derived from sales of OmniPage, OmniForm, and
PageKeeper products, and beginning in 1997, Recognita Plus. Hardware products
consist of transaction processing optical character recognition ("OCR") and bar
code products.

Business Line Analysis

<TABLE>
<CAPTION>
                                            1998                                1997                                 1996
(In thousands)     Software    Hardware                Software     Hardware                Software    Hardware
                   Products    Products    Combined    Products     Products   Combined     Products    Products    Combined
                   --------    --------    --------    --------     --------   --------     --------    --------    --------
<S>                <C>         <C>        <C>         <C>          <C>        <C>          <C>         <C>         <C>    
Net revenues        $57,351     $ 8,451     $65,802     $47,119     $ 7,899     $55,018     $45,797     $ 8,731     $54,528
Cost of revenues      9,963       4,181      14,144      10,260       4,060      14,320      12,798       3,675      16,473
                    -------     -------     -------     -------     -------     -------     -------     -------     -------
                    $47,388     $ 4,270     $51,658     $36,859     $ 3,839     $40,698     $32,999     $ 5,056     $38,055
Gross margin %         82.6%       50.5%       78.5%       78.2%       48.6%       74.0%       72.1%       57.9%       69.8%
                    -------     -------     -------     -------     -------     -------     -------     -------     -------
</TABLE>


Net revenues from software products represented about 87 percent, 86 percent,
and 84 percent of total net revenues for 1998, 1997, and 1996, respectively. To
the extent the demand for the Company's software products continues to broaden,
the Company anticipates that net revenues from software products during 1999
will continue to comprise a similar significant portion of its total net
revenues as seen over this three-year period. Over 90 percent of all software
revenues were derived from Windows-based products in 1998, and the Company
anticipates that this will continue in 1999.

Net revenues for software products of $57.4 million in 1998 represented an
increase of approximately 22 percent over 1997. This growth is primarily
attributable to increased royalties received from scanner manufacturers bundling
the Company's limited-featured OCR and document management software and
increased unit sales of both the OmniPage family of products, especially
OmniPage Pro 9.0 which first shipped in October 1998, and OmniForm. Net software
product revenues of $47.1 million in 1997 represented an increase of
approximately three percent over 1996. This slight growth was primarily
attributable to increased royalties received and increased unit sales of the
Windows-based versions of the OmniPage family of products, offset by a decline
in units sales of Macintosh-based software products.



<PAGE>   3

Net revenues for hardware products increased about seven percent to $8.4 million
in 1998, compared to $7.9 million in 1997. This reflects a slight increase in
the unit sales of hardware products in 1998 compared to 1997. The decrease in
net revenues in 1997 compared to 1996, however, was primarily attributable to
the market's transition from certain hardware products designed for high-volume
OCR applications to software only solutions. As customers employ such software
only solutions, sales of the comparable hardware products decline. Historically,
there have been fluctuations in sales patterns for the Company's hardware
products. In particular, the periodic award of large sales contracts tends to
make shipments difficult to predict. As a result, fluctuations in net revenues
between quarters are expected to continue in the future.

International sales have increased in absolute dollars in each of the last three
years, and represented about 34 percent, 34 percent, and 30 percent of total net
revenues in 1998, 1997 and 1996, respectively. The Company believes that
continued growth in international sales will be important for the Company's
future success, and as a result, the Company intends to continue to invest in
expanding its operations internationally, particularly in Europe. Sales growth
in these markets, however, has been and will continue to be impacted by certain
factors beyond the control of the Company, such as variable economic conditions,
foreign currency exchange rates, slower adoption of OCR and document management
technologies, and government regulation.

Gross Margin

Gross margin represents net revenues less cost of revenues. Cost of revenues
consists primarily of manufacturing and production expenses, packaging costs,
royalties paid to third parties, and amortization and write-off of capitalized
software development costs.

Cost of revenue as a percentage of total net revenue was 21 percent in 1998, 26
percent in 1997, and 30 percent in 1996. Although cost of revenue as a
percentage of total net revenue decreased in 1998 and 1997, it varies with
channel mix and product mix within channels. The trend of declining cost of
revenue as a percentage of revenue may not continue in 1999.

Overall gross margins were 79 percent in 1998, 74 percent in 1997, and 70
percent in 1996. This trend was due primarily to product mix being more heavily
weighted towards software products, which generally have higher gross margins
than do hardware products.

Gross margins for software products were 83 percent in 1998, 78 percent in 1997,
and 72 percent in 1996. This trend of increasing gross margin for software
products is largely attributable to changes made in certain bundling
arrangements with original equipment manufacturers ("OEM") where the Company
shifted the cost of manufacturing its limited-featured bundled products to these
OEM partners. Under such agreements, rather than selling manufactured software
products to such partners at very low prices, the Company allows such OEM
partners to produce their own requirements on a reduced royalty basis. This
transition has the effect of reducing the Company's revenues by amounts nearly
equal to the reduction in associated cost of revenues for such bundled product,
resulting in an improvement in overall gross margin percentage for software
products. This type of arrangement with OEM partners is expected to continue in
1999. Also contributing to the improved gross margin percentages in 1998 and
1997 were increasing production volumes generated by the Company's bundle and
upgrade strategy, as well as increased royalty revenue.

Gross margins for hardware products were 51 percent in 1998, 49 percent in 1997,
and 58 percent in 1996. The fluctuation in gross margins over this three-year
period reflects the weakness of hardware product net revenues in 1998 and 1997
compared to 1996. In addition, demand for certain hardware products has lessened
over the last couple of years as customers have turned to software only
solutions. Since a significant portion of hardware cost of revenues relates to
fixed manufacturing overhead costs, the gross margins for hardware will often
decline during periods of flat or negative revenue and unit shipment growth.
Also contributing to lower gross margins on hardware products were certain price
reductions over the last several years.

The primary factor affecting overall gross margins in the future is likely to be
shifts in product mix between fully-priced, non-upgrade software, bundled
software, and upgrade products, as well as overall shifts in product mix between
software and hardware products. In addition, the software market has been
subject to rapid changes, including significant price competition, which can be
expected to continue. Future technology or market changes may cause certain
products to become obsolete rapidly, necessitating increased inventory
write-offs or reserves and a corresponding decrease in gross margins.

Capitalized Software

In accordance with Statement of Financial Accounting Standards No. 86, the
Company capitalized $280,000 of software development costs in 1998 compared to
$858,000 during 1997 and $561,000 during 1996. Amortization of capitalized
software development costs was $678,000 in 1998, $508,000 in 1997, and $734,000
in 1996.

Operating Expenses

Research and Development

Caere continued to invest heavily in the future by funding research and
development ("R&D"). Expense increases of 33 percent in both 1998 and 1997,
resulted primarily from development staff headcount growth and higher levels of
third-party development costs in many areas, particularly in software
technologies. The sustained commitment to R&D over the last two


<PAGE>   4


years allowed the Company to successfully launch multiple products in 1998,
including OmniPage Pro 9.0, OmniPage Wizard, PageKeeper Standard, and an
all-in-one Professional Developers Kit. In some cases, R&D efforts for these
products began well over a year before their launch. The Company believes that
significant R&D investments in 1999, and beyond, will be necessary for the
Company to effectively compete in the software market.

Selling, General and Administrative

The increase in the absolute dollar amounts of selling, general and
administrative ("SG&A") expenses in the three-year period was due principally to
expanded product-specific marketing programs, expansion of distribution
channels, and growth in computer and information systems, and business
infrastructure necessary to support overall increases in the scope of the
Company's operations. As a percentage of net revenue, SG&A expense was 43
percent in 1998, 49 percent in 1997, and 48 percent in 1996. Caere expects that
SG&A expense will increase in absolute dollar terms in 1999 as efforts to expand
sales and marketing activities continue both domestically and internationally.

In-Process Research and Development

During 1997, in connection with the acquisition of Formonix, Inc., acquired
in-process research and development of about $2.9 million was charged to
operations during the Company's first fiscal quarter. During 1996, in connection
with the acquisition of Recognita, acquired in-process research and development
of approximately $4.4 million was charged to operations during the Company's
fourth fiscal quarter. See Note 8 of Notes to the Consolidated Financial
Statements for additional information on these two acquisitions.

Interest Income and Income Taxes

Interest income was $2.6 million in 1998, $2.5 million in 1997, and $2.7 million
in 1996. The effective income tax rate increased to 25 percent in 1998. The
effective income tax rate was 22 percent in 1997 and 20 percent in 1996. The
effective income tax rate continues to be lower than the U.S. federal statutory
tax rate primarily due to benefits derived from federal net operating loss
carryforwards and the Company's utilization of a foreign sales corporation. In
future years, depending on profitability, the Company may be able to utilize
approximately $2.7 million of federal net operating loss carryforwards per year.

Certain Trends, Issues and Uncertainties

The Company's future operating results may be affected by various uncertain
trends and factors which are beyond the Company's control. These include, but
are not limited to, adverse changes in general economic conditions, rising
costs, or the occasional unavailability of needed components. The industry is
characterized by rapid changes in the technologies affecting optical character
recognition, forms, and desktop document management. The industry has also
become increasingly competitive, and, accordingly, the Company's results may
also be adversely affected by the actions of existing or future competitors,
including the development of new technologies, the introduction of new products,
and the reduction of prices by such competitors to gain or retain market share.

The Company's future earnings and stock price could be subject to significant
volatility, particularly on a quarterly basis. The Company's revenues and
earnings are unpredictable due to the Company's shipment patterns. As is common
in the software industry, the Company's experience has been that a
disproportionately large percentage of shipments has occurred in the third month
of each fiscal quarter, and shipments tend to be concentrated in the latter half
of that month. Because the Company's backlog early in a quarter is not generally
large enough to assure that it will meet its revenue targets for any particular
quarter, quarterly results are difficult to predict until the end of the
quarter. A shortfall in shipments at the end of any particular quarter may cause
the results for that quarter to fall significantly short of anticipated levels.
Due to analysts' expectations of continued growth, any such shortfall in
earnings could have a very significant adverse effect on the trading price of
the Company's common stock in any given period.

As a result of the foregoing factors and other factors which may arise in the
future, the market price of the Company's common stock may be subject to
significant fluctuations over a short period of time. These fluctuations may be
due to factors specific to the Company, to changes in analysts' earnings
estimates, or to factors affecting the computer industry or the securities
markets in general.

Year 2000 and Potential Consequences

Like many other companies, the Year 2000 computer issues create certain risks
for the Company. If the Company's internal management information systems or
products sold to customers do not correctly recognize and process date
information beyond the year 1999, there could be an adverse impact on the
Company's operations.

The Company is addressing a broad range of issues associated with the
programming code in existing computer systems as the year 2000 approaches. Many
currently installed computer systems and software products are coded to accept
only two digit entries in the date code field. These date code fields will need
to accept four digit entries to distinguish 21st century dates from 20th century
dates. This is frequently referred to as the "Year 2000 Problem." If the
Company's internal management information systems and products do not correctly
recognize and process date information beyond the year 1999, there could be an
adverse impact on the Company's operations. In mid-1997, Caere initiated a
company-wide Year 2000 Project to address this issue. A Year 2000 Committee was
established and mandated with defining, assessing, and converting, or replacing,
various programs, hardware, and instrumentation systems to make them Year 2000
compatible.



<PAGE>   5

1. Status of Readiness: To address the Year 2000 issues with its internal
information technology ("IT") systems, the Company has initiated a program to
evaluate its internal systems, including manufacturing, sales, and financial
systems. The Company has completed the assessment phase and the renovation and
testing phases are proceeding in parallel. The Company's assessment indicated
that certain internal IT systems should be upgraded or replaced as part of a
solution to the Year 2000 problem. All of the hardware and most of the software
for the Company's internal IT systems come from third-party suppliers and are
being remediated by them.

Although the Company's non-IT systems do not in many cases directly impact the
Company's core business, they remain an important part of Caere's Year 2000
efforts. All mission-critical non-IT systems and products have the same target
dates for remediation and interoperability testing as their network element and
information system counterparts. Caere is currently evaluating the Year 2000
readiness of its non-IT systems with a comprehensive inventory of monitoring and
control devices for premises, safety systems, and other similar operating
installations. Caere has communicated with all mission critical suppliers and
service providers about their plans for Year 2000 compliance. Plans detailing
the tasks and resources required to ensure Year 2000 readiness of non-IT systems
by the end of June 1999 are expected to be in place by March 31, 1999.

The Company's Year 2000 Project for internal systems is scheduled to be
completed by mid-1999. The chart below shows the overall status of Caere's
five-phase Year 2000 project in the following areas:


<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------------------------
                  Awareness       Assessment      Renovation              Testing                Implementation
                                                                                               
-----------------------------------------------------------------------------------------------------------------
<S>              <C>             <C>             <C>                     <C>                    <C>
IT Systems        Completed       Completed       Underway with           Underway with          Planning and
                                                  approximately 25%       approximately 35%      scheduling
                                                  completed.              completed.             underway.
                                                  Mission critical        Mission critical       Scheduled to be
                                                  elements scheduled      elements               completed by
                                                  to be completed by      scheduled to be        mid-1999
                                                  mid-1999                completed by         
                                                                          mid-1999             
-----------------------------------------------------------------------------------------------------------------
Non-IT            Completed       Completed       Underway with           Underway with          Planning and
Systems                                           approximately 20%       approximately 20%      scheduling
                                                  completed.              completed.             underway.
                                                  Mission critical        Mission critical       Scheduled to be
                                                  elements scheduled      elements               completed by
                                                  to be completed by      scheduled to be        mid-1999
                                                  mid-1999                completed by         
                                                                          mid-1999             
-----------------------------------------------------------------------------------------------------------------
</TABLE>


The Company is in the process of identifying and prioritizing critical third
parties and customers, and will follow up with them concerning their plans and
progress in addressing the Year 2000 problem. The Company is also working with
key suppliers of products and services to determine that their operations and
products are Year 2000 compliant or to monitor their progress toward Year 2000
compliance, as appropriate.

In the Company's standard license agreements, the Company warrants to licensees
that its software routines and programs are Year 2000 compliant. If any of the
Company's licensees experience Year 2000 problems, such licensee could assert
claims for damages against the Company. Any such litigation could result in
substantial costs and diversion of the Company's resources, even if ultimately
decided in favor of the Company.

The Company believes that all products currently shipping and supported by Caere
will be "Year 2000 Compliant." It is likely that some older products may not be
Year 2000 Compliant. As used by Caere, "Year 2000 Compliant" means that when
used properly and in conformity with the product information provided by the
Company, and when used with "Year 2000 Compliant" computer systems, the product
will accurately store, display, process, provide, and/or receive data from,
into, and between the twentieth and twenty-first centuries, including leap year
calculations, provided that all other technology used in combination with the
Caere product properly exchanges date data with the Caere product. There can be
no assurance that (i) third party technologies used in combination with Caere
products will be Year 2000 Compliant and (ii) Caere products will not be
adversely affected when used with such third party technologies, nor can the
Company represent that any modifications to its products made by a party other
than Caere will be Year 2000 Compliant.

2. Costs Associated with the Year 2000 Project: Costs associated with certain
system upgrades are included in existing operating budgets. In some instances
(such as the Company's financial administrative system), the installation
schedule of new software and hardware in the normal course of business is being
accelerated to also afford a solution to Year 2000 compliance issues. Certain of
the costs related to upgrades of hardware and software systems are covered by
ongoing maintenance agreements. Additional costs of purchasing, installing,
modifying and testing the internal systems are not


<PAGE>   6


expected to exceed $800,000. The total cost associated with required
modifications to become Year 2000 Compliant is estimated at $1,000,000.

The total cost estimate is based on the current assessment of the projects and
is subject to change as the project progresses. Based on currently available
information, the Company does not believe that the Year 2000 matters discussed
above related to internal systems or products sold to customers will have a
material adverse impact on its financial condition or overall trends in results
of operations; however, it is still uncertain to what extent the Company may be
affected by such matters. In addition, customers may delay purchase decisions
because of uncertainty about Year 2000 issues. There also can be no assurance
that the failure to ensure Year 2000 compliance by a supplier or another third
party would not have a material adverse effect on the Company.

3. Contingency Plans: The Company has begun internal discussions concerning
contingency planning to address potential problem areas with internal systems
and with suppliers and other third parties. It is expected that remediation and
contingency planning activities will be on-going throughout calendar year 1999
with the goal of appropriately resolving all material internal systems and third
party issues.

Financial Condition

Caere's cash and short-term investment portfolio totaled $44.3 million at
December 31, 1998. The portfolio is diversified among security types,
industries, and individual issuers. The portfolio is invested primarily in
short-term, U.S. dollar denominated securities to both minimize interest rate
risk and maintain liquidity in the event of immediate cash needs.

Caere offers credit terms to qualifying customers and also sells products on a
prepaid, credit card and cash-on-delivery basis. For credit sales, the Company
attempts to control its bad debt exposure through monitoring of customers'
creditworthiness and, where practicable, through participation in credit
associations that provide credit rating information about its customers. The
Company has also purchased credit insurance for certain key accounts to reduce
the potential for catastrophic losses.

Caere has no long-term debt. The Company has not paid cash dividends on its
common stock. Stockholders' equity at December 31, 1998 was $56.2 million.

Caere will continue to invest in its sales, marketing, and product support
infrastructures. In addition, research and development investments will continue
to be made in existing and advanced areas of technology, including using cash to
acquire technology and to fund other strategic opportunities. Additions to
property and equipment will continue, including new facilities and computer
systems for research and development, sales and marketing, support, and
administrative staff.

Cash will also continue to be used to repurchase common stock. Among other
purposes, the shares will be used for employee stock option and purchase plans.
The Company repurchased approximately 1.5 million shares of common stock in 1998
with an aggregate cost of approximately $19.8 million. 

Management believes that existing cash and short-term investments together with
funds generated from operations will be sufficient to meet operating and capital
expenditure requirements for at least the next 12 months.


<PAGE>   7

CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                      December 31,   
                                                   ------------------
                                                     1998       1997
                                                   -------    -------
<S>                                                <C>        <C>    
(In thousands, except share and per share data)                 

Assets

Current assets:

 Cash and cash equivalents                         $15,753    $16,417
 Short-term investments                             28,584     33,156
 Receivables                                         7,336      5,263
 Inventories                                         1,953      1,917
 Deferred income taxes                               2,953      3,241
 Other current assets                                  422        990
                                                   -------    -------
  Total current assets                              57,001     60,984

Property and equipment, net                          3,640      4,781
Other assets                                         3,243      1,535
                                                   -------    -------
                                                   $63,884    $67,300
                                                   =======    =======

Liabilities and Stockholders' Equity

Current liabilities:

 Accounts payable                                  $ 2,691    $ 2,145
 Accrued expenses                                    5,020      3,946
                                                   -------    -------
  Total current liabilities                          7,711      6,091
                                                   -------    -------

Commitments and contingencies

Stockholders' equity:
 Preferred stock, $.001 par value; authorized
   2,000,000 shares; none issued or outstanding         --         --
 Common stock, $.001 par value; authorized
   30,000,000 shares; issued and outstanding
   12,072,028 and 13,107,235 shares                     12         13
 Additional paid-in capital                         42,409     57,720
 Retained earnings                                  13,752      3,476
                                                   -------    -------
   Total stockholders' equity                       56,173     61,209
                                                   -------    -------
                                                   $63,884    $67,300
                                                   =======    =======
</TABLE>


See accompanying notes to consolidated financial statements.


<PAGE>   8




CONSOLIDATED STATEMENTS OF EARNINGS



<TABLE>
<CAPTION>
                                                      Years Ended December 31, 
                                                  --------------------------------
                                                    1998        1997        1996
                                                  --------    --------    --------
<S>                                               <C>         <C>         <C>     
(In thousands, except per share data)

Net revenues                                      $ 65,802    $ 55,018    $ 54,528
Cost of revenues                                    14,144      14,320      16,473
                                                  --------    --------    --------
                                                    51,658      40,698      38,055
                                                  --------    --------    --------

Operating expenses:
 Research and development                           12,442       9,370       7,069
 Selling, general and administrative                28,136      26,878      26,193
 In-process research and development                    --       2,935       4,373
                                                  --------    --------    --------
                                                    40,578      39,183      37,635
                                                  --------    --------    --------

  Operating earnings                                11,080       1,515         420

Interest income                                      2,621       2,502       2,692
Writedown of investment in ZyLAB International          --          --      (2,616)
                                                  --------    --------    --------
  Earnings before income taxes                      13,701       4,017         496

Income tax expense                                   3,425         877         100
                                                  --------    --------    --------
  Net earnings                                    $ 10,276    $  3,140    $    396
                                                  ========    ========    ========

Basic earnings per share                          $    .81    $    .24    $    .03
Diluted earnings per share                        $    .78    $    .24    $    .03

Weighted average number of shares used in per
share computations:
   Basic                                            12,687      13,123      13,120
   Diluted                                          13,246      13,265      13,319
</TABLE>




See accompanying notes to consolidated financial statements.

<PAGE>   9

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY


<TABLE>
<CAPTION>
                                                                           
                                                  Common stock             Additional        Retained         Total     
                                           ---------------------------       paid-in         earnings      stockholders'
                                             Shares           Amount         capital        (deficit)         equity
                                           -----------     -----------     -----------     -----------     -----------
<S>                                         <C>            <C>             <C>             <C>             <C>        
(In thousands, except share data)


Balances at December 31, 1995               13,283,224     $        13     $    62,075     $       (60)    $    62,028

 Repurchase of stock                        (1,000,000)             --          (9,233)             --          (9,233)
 Exercise of stock options                     240,438              --           1,560              --           1,560
 Issued pursuant to stock purchase plan        106,922              --             650              --             650
 Tax benefit associated with
    exercise of stock options                       --              --             296              --             296
 Other                                              --              --              51              --              51
 Net earnings                                       --              --              --             396             396
                                           -----------     -----------     -----------     -----------     -----------

    Balances at December 31, 1996           12,630,584              13          55,399             336          55,748

 Repurchase of stock                          (237,444)             --          (2,000)             --          (2,000)
 Exercise of stock options                      61,980              --             410              --             410
 Issued pursuant to stock purchase plan        102,115              --             658              --             658
 Issued for  acquisition  of  Formonix,        550,000              --           3,105              --           3,105
    Inc. 
 Tax benefit associated with
    exercise of stock options                       --              --              57              --              57
 Other                                              --              --              91              --              91
 Net earnings                                       --              --              --           3,140           3,140
                                           -----------     -----------     -----------     -----------     -----------

    Balances at December 31, 1997           13,107,235              13          57,720           3,476          61,209

 Repurchase of stock                        (1,546,000)             (1)        (19,825)             --         (19,826)
 Exchanged for option exercises                (33,013)             --            (477)             --            (477)
 Exercise of stock options                     435,424              --           3,498              --           3,498
 Issued pursuant to stock purchase plan        108,382              --             798              --             798
 Tax benefit associated with
    exercise of stock options                       --              --             698              --             698
 Other                                              --              --              (3)             --              (3)
 Net earnings                                       --              --              --          10,276          10,276
                                           -----------     -----------     -----------     -----------     -----------

    Balances at December 31, 1998           12,072,028     $        12     $    42,409     $    13,752     $    56,173
                                           ===========     ===========     ===========     ===========     ===========
</TABLE>



See accompanying notes to consolidated financial statements.



<PAGE>   10

CONSOLIDATED STATEMENTS OF CASH FLOWS



<TABLE>
<CAPTION>
                                                                              Years Ended December 31,
                                                                         ----------------------------------
                                                                           1998         1997         1996
                                                                         --------     --------     --------
                                                                                   (In thousands)  
<S>                                                                      <C>          <C>          <C>     
Cash flows from operating activities:
 Net earnings                                                            $ 10,276     $  3,140     $    396
 Adjustments to reconcile net earnings to net cash provided
   by operating activities:
     Depreciation and amortization                                          3,013        3,130        2,689
     In-process research and development                                       --        2,935           --
     Merger related costs                                                      --           --         (930)
     Write-down of investment in ZyLAB International                           --           --        2,616
     Amortization of capitalized software
        development costs                                                     678          508          734
     Deferred income taxes                                                   (991)        (991)      (1,301)
     Loss on disposition of assets                                             --          111           --
     Changes in operating assets and liabilities:
       Receivables                                                         (2,073)       1,625         (708)
       Income tax receivable                                                   --           --        1,109
       Inventories                                                            (36)         862         (702)
       Other current assets                                                   568         (222)          (2)
       Accounts payable                                                       546       (1,336)         537
       Accrued expenses                                                     1,074           21          893
                                                                         --------     --------     --------

     Net cash provided by operating activities                             13,055        9,783        5,331
                                                                         --------     --------     --------

Cash flows from investing activities:
   Short-term investments, net                                              4,572         (529)       4,474
   Capital expenditures                                                    (1,362)      (2,786)      (1,460)
   Capitalized software development costs                                    (280)        (858)        (561)
   Other assets                                                            (1,337)         (72)        (109)
                                                                         --------     --------     --------

     Net cash provided by (used for) investing activities                   1,593       (4,245)       2,344
                                                                         --------     --------     --------

Cash flows from financing activities:
   Proceeds from issuances of common stock                                  3,819        1,068        2,261
   Tax benefit associated with exercise of stock options                      698           57          296
   Repurchase of stock                                                    (19,826)      (2,000)      (9,233)
   Other                                                                       (3)          91           --
                                                                         --------     --------     --------
     Net cash used for financing activities                               (15,312)        (784)      (6,676)
                                                                         --------     --------     --------

     Net change in cash and cash equivalents                                 (664)       4,754          999

Cash and cash equivalents at beginning of year                             16,417       11,663       10,664
                                                                         --------     --------     --------

Cash and cash equivalents at end of year                                 $ 15,753     $ 16,417     $ 11,663
                                                                         ========     ========     ========

Supplemental disclosures:
  Cash paid for income taxes                                             $  3,402     $  1,202     $    162
                                                                         ========     ========     ========
  Non-cash investing and financing activities:
    Acquisition of Formonix for common stock                             $     --     $  3,105     $     --
                                                                         ========     ========     ========
</TABLE>




See accompanying notes to consolidated financial statements. 



<PAGE>   11

Notes to the Consolidated Financial Statements
December 31, 1998, 1997, and 1996



1. Company and Significant Accounting Policies
The Company. Caere Corporation (the "Company") designs, develops, manufactures,
and markets information recognition software and products. The Company
distributes a range of information recognition software and equipment through
channels of original equipment manufacturers, value added resellers,
distributors, and retail distributors.

In December 1996, the Company acquired Recognita Rt. ("Recognita"), a developer
of recognition and forms software and products. This acquisition was accounted
for using the purchase method of accounting. Accordingly, the consolidated
results of the Company only include Recognita's results of operations since the
date of acquisition.

In March 1997, the Company acquired Formonix, Inc. ("Formonix"), a developer of
forms software and products. This acquisition was accounted for using the
purchase method of accounting. Accordingly, the consolidated results of the
Company only include Formonix's results of operations since the date of
acquisition.

Segment Reporting. In June 1997, the Financial Accounting Standards Board
("FASB") issued Statement of Financial Accounting Standard ("SFAS") No. 131,
"Disclosures About Segments of an Enterprise and Related Information." SFAS No.
131 establishes standards for the manner in which public companies report
information about operating segments in annual and interim financial statements.
It also establishes standards for related disclosures about products and
services, geographic areas and major customers. The Company has determined that
it operates in a single operating segment: information recognition software and
products.

Use of Estimates. The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expenses during the reporting
period. Actual results could differ from those estimates.

Principles of Consolidation. The accompanying financial statements include the
accounts of the Company and its wholly owned subsidiaries after elimination of
intercompany transactions. Foreign Currency Translation. The financial
statements of the Company's foreign subsidiaries, where the local currency is
the functional currency, are translated using the exchange rate in effect at the
end of the year for assets and liabilities and average exchange rates during the
year for revenues and expenses. The resulting currency translation adjustments
have not been material. The Company enters into transactions denominated in
foreign currencies and includes the exchange gain or loss arising from such
transactions in current operations. Such gains and losses have not been
material.

Cash, Cash Equivalents, and Short-Term Investments. Cash and cash equivalents
consist of cash on deposit with banks and highly liquid money market instruments
with purchased maturities of 90 days or less. Certain cash equivalents and all
investments have been classified as available-for-sale and are stated at fair
value (approximates cost) at December 31, 1998 and 1997.

In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities." SFAS No. 133 is effective for all fiscal
quarters of all fiscal years beginning after June 15, 1999. SFAS No. 133
requires that all derivative instruments be recorded on the balance sheet at
their fair value. Changes in the fair value of derivatives are recorded each
period in current earnings or other comprehensive income, depending on whether a
derivative is designed as part of a hedge transaction and, if it is, the type of
hedge transaction. The Company does not expect that the adoption of SFAS No. 133
will have a material impact on its consolidated financial statements.

Inventories. Inventories are stated at the lower of first-in, first-out cost or
market.

Property and Equipment. Property and equipment are stated at cost less
accumulated depreciation and amortization. Depreciation is provided over the
estimated useful lives of the respective assets, generally three to five years,
on a straight-line basis. Leasehold improvements are amortized on a
straight-line basis over the shorter of the lease terms or the lives of the
respective assets. Recoverability of property and equipment is measured by
comparison of its carrying amount to future net cash flows the property and
equipment are expected to generate. If such assets are considered to be
impaired, the impairment to be recognized is measured by the amount by which the
carrying amount of the property and equipment exceeds its fair market value. To
date, the Company has made no adjustments to the carrying values of its
long-lived assets.

Software Development Costs. The Company capitalizes software development costs
incurred subsequent to determining a product's technological feasibility. Such
costs are amortized on a straight-line basis over the estimated useful life of
the product, generally two to three years. Included in other assets at December
31, 1998 and 1997, are capitalized software development costs aggregating
$5,908,000 and $5,628,000, respectively, and related accumulated amortization of
$5,333,000 and $4,655,000, respectively.



<PAGE>   12

Revenue Recognition. Revenue is recognized when (i) evidence of an arrangement
exists, (ii) delivery has occurred, (iii) the fee is fixed or determinable, and
(iv) collectibility is probable. In addition, provisions are recorded for the
limited rights to exchange products and price protection on unsold merchandise
granted to certain distributors.

In October 1997, the American Institute of Certified Public Accountants
("AICPA") issued Statement of Position ("SOP") 97-2, "Software Revenue
Recognition," which supersedes SOP 91-1. The Company adopted SOP 97-2 for
software transactions entered into beginning January 1, 1998. SOP 97-2 generally
requires revenue earned on software arrangements involving multiple elements
such as software products, upgrades, enhancements, post-contract customer
support, installation, and training to be allocated to each element based on the
relative fair values of the elements. The fair value of an element must be based
on evidence that is specific to the vendor. If a vendor does not have evidence
of the fair value for all elements in a multiple-element arrangement, all
revenue from the arrangement is deferred until such evidence exists or until all
elements are delivered. There was no material change to the Company's accounting
for revenues as a result of the adoption of SOP 97-2.

In February 1998, the AICPA issued SOP 98-4, "Deferral of the Effective Date of
SOP 97-2." SOP 98-4 defers the effective date for applying the provisions
regarding vendor-specific objective evidence of fair value ("VSOE") until the
AICPA can reconsider what constitutes such VSOE. There was no material change to
the Company's accounting for revenues as a result of the adoption of SOP 98-4.

In December 1998, the AICPA issued SOP 98-9, "Software Revenue Recognition, with
Respect to Certain Arrangements," which requires recognition of revenue using
the "residual method" in a multiple-element arrangement when fair value does not
exist for one or more of the delivered elements in the arrangement. Under the
residual method, the total fair value of the undelivered elements is deferred
and subsequently recognized in accordance with SOP 97-2. The Company does not
expect a material change to its accounting for revenues as a result of the
provisions of SOP 98-9.

Stock-Based Compensation. The Company uses the intrinsic value method to account
for stock-based compensation.

Income Taxes. Caere recorded income tax expense during all periods using the
asset and liability approach that results in the recognition of deferred tax
assets and liabilities for the expected future tax consequences of events that
have been recognized in Caere's financial statements or tax returns. In
estimating future tax consequences, Caere generally considers all expected
future events other than enactment of changes in tax laws or rates. A valuation
allowance is recognized for the portion of deferred tax assets whose
realizability is not considered more likely than not.

Earnings Per Share. Basic earnings per share is computed using the
weighted-average number of common shares outstanding for the period. Diluted
earnings per share is based on the weighted-average common shares outstanding
for the period plus dilutive common equivalent shares including stock options
using the treasury stock method.

Comprehensive Income. The Company has no significant components of other
comprehensive income and, accordingly, comprehensive income is the same as net
earnings for all periods.

2. Cash Equivalents and Short-Term Investments
Certain cash equivalents and all short-term investments have been classified as
available-for-sale securities, and consisted of the following as of December 31,
1998 and 1997:


<TABLE>
<CAPTION>
                                                               December 31,
                                                           ---------------------
                                                            1998          1997
                                                           -------       -------
                                                               (In thousands)
<S>                                                        <C>           <C>    
Corporate bonds and notes                                  $11,989       $ 8,868
Commercial paper                                            14,201        20,053
Certificates of deposit                                         --           600
U.S., State and municipal bonds                              4,004         6,181
Corporate auction-rate preferred securities                 11,525        11,500
Money market funds                                             488         1,139
                                                           -------       -------
                                                           $42,207       $48,341
                                                           =======       =======
</TABLE>

The Company's investments are classified as follows:

<TABLE>
<CAPTION>
                                                               December 31,
                                                           ---------------------
                                                            1998           1997
                                                           -------       -------
                                                                (In thousands)
<S>                                                       <C>           <C>    
Cash equivalents                                           $13,623       $15,185
Short-term investments                                      28,584        33,156
                                                           -------       -------
                                                           $42,207       $48,341
                                                           =======       =======
</TABLE>




<PAGE>   13




The cost and estimated fair value of available-for-sale securities as of
December 31, 1998, by contractual maturity, consisted of the following:

<TABLE>
<CAPTION>
                                                Estimated
                                                fair value
                                                 -------
                                              (In thousands)  
<S>                                             <C>    
Due in one year or less                          $ 2,212
Due in more than one year                         14,847
Auction-rate securities                           11,525
                                                 -------
                                                 $28,584
                                                 =======
</TABLE>


Auction-rate preferred securities are taxable investments without a stated
expiration date. The Company has the option of adjusting the respective interest
rates or liquidating these investments at auction on stated auction dates which
range from seven to 28 days.

3. Receivables

A summary of receivables follows:


<TABLE>
<CAPTION>
                                                               December 31,
                                                           ---------------------
                                                            1998           1997
                                                           -------       -------
                                                               (In thousands)
<S>                                                        <C>           <C>    
Trade accounts receivable                                  $ 8,888       $ 6,767
Interest receivable                                            405           583
                                                           -------       -------
                                                             9,293         7,350
Less allowances for returns and doubtful accounts            1,957         2,087
                                                           -------       -------
                                                           $ 7,336       $ 5,263
                                                           =======       =======
</TABLE>


The Company's credit risk is concentrated primarily in trade receivables from
dealers and distributors of hardware and software products who sell into the
retail market (see Note 13). Historically, the Company has not experienced
significant losses related to receivables from individual customers or groups of
customers in any particular industry.

4. Inventories

A summary of inventories follows:


<TABLE>
<CAPTION>
                                                                December 31,
                                                           ---------------------
                                                            1998          1997
                                                           -------       -------
                                                                (In thousands)
<S>                                                        <C>           <C>    
Raw materials                                              $   690       $   738
Work in process                                                406           226
Finished goods                                                 857           953
                                                           -------       -------
                                                           $ 1,953       $ 1,917
                                                           =======       =======
</TABLE>

5. Property and Equipment

A summary of property and equipment follows:


<TABLE>
<CAPTION>
                                                               December 31,
                                                             1998         1997
                                                           -------       -------
                                                               (In thousands) 
<S>                                                        <C>           <C>    
Equipment                                                  $13,755       $12,466
Furniture and fixtures                                       1,925         1,896
Leasehold improvements                                       1,661         1,617
                                                           -------       -------
                                                            17,341        15,979
Less accumulated depreciation
 and amortization                                           13,701        11,198
                                                           -------       -------
                                                           $ 3,640       $ 4,781
                                                           =======       =======
</TABLE>


<PAGE>   14

6. Accrued Expenses

A summary of accrued expenses follows:

<TABLE>
<CAPTION>
                                                               December 31,
                                                           ---------------------
                                                             1998          1997
                                                           -------       -------
                                                              (In thousands)  
<S>                                                        <C>           <C>    
Accrued payroll costs                                      $ 1,493       $ 1,125
Accrued royalties                                              449           250
Accrued professional fees                                      368           243
Income taxes payable                                         1,368         1,247
Other accrued expenses                                       1,342         1,081
                                                           -------       -------
                                                           $ 5,020       $ 3,946
                                                           =======       =======
</TABLE>

7. Commitments and Contingencies

The Company leases certain facilities under noncancelable operating leases that
expire in 2004. As of December 31, 1998, future minimum lease payments under
noncancelable operating leases were $971,000, $1,030,000, $1,078,000,
$1,302,000, and $1,352,000 for each of the years through the period ending
December 31, 2003.

Rent expense was approximately $858,000 in 1998, $784,000 in 1997, and $692,000
in 1996. The Company is responsible for taxes and insurance in connection with
its facilities leases.

There are certain claims against the Company arising in the normal course of
business. The extent to which these matters will be pursued by the claimants or
the eventual outcome is not presently determinable; however, the Company
believes that the ultimate resolution of these matters will not have a material
adverse effect on its consolidated financial position or results of operations.

8. Mergers and Acquisitions

On December 18, 1996, the Company acquired Recognita. Total costs of the
acquisition were $4,868,000. The purchase price of $3,000,000 was paid in cash
prior to the end of fiscal 1996. Acquisition costs associated with the
transaction totaled $1,090,000 and consisted mainly of professional fees. The
Company also assumed $778,000 of debt in conjunction with the acquisition. This
business combination was accounted for under the purchase method of accounting.
Accordingly, Recognita's results of operations have been included in the
Company's consolidated results of operations since the date of acquisition.

The purchase price was allocated among the identifiable assets of Recognita.
After allocating the purchase price to the net tangible assets, acquired
technology was valued using a risk-adjusted cash flow model, under which future
expected cash flows were discounted taking into account risks related to
existing markets, the technology's life expectancy, future target markets and
potential changes thereto, and the competitive outlook for the technology. This
analysis resulted in an allocation of $4,373,000 to in-process technology which
had not yet reached technological feasibility and had no alternative future use,
and accordingly, was charged to expense.

The following summarized, pro forma results of operations for the year ended
December 31, 1996 assume the acquisition took place at the beginning of the year
and exclude the $4,373,000 charge for acquired in-process technology.


<TABLE>
<S>                                                 <C>
(In thousands, except per share amounts)

Net revenues                                          $56,683
Net earnings                                          $ 4,446
Basic earnings per share                              $   .33
Diluted earnings per share                            $   .33
</TABLE>


On March 31, 1997, the Company acquired Formonix. Total value of the acquisition
was approximately $3,188,000. The Company issued 550,000 shares of common stock
in exchange for all of the capital stock of Formonix Using the closing price of
the Company's stock on the closing date of the acquisition the valuation of the
shares issued was approximately $3,105,000. Acquisition costs associated with
the transaction totaled approximately $83,000 and consisted mainly of
professional fees. This business combination was accounted for under the
purchase method of accounting. Accordingly, Formonix's results of operations
have been included in the Company's consolidated results of operations since the
date of acquisition.

The purchase price was allocated among the identifiable assets of Formonix.
After allocating the purchase price to the net tangible assets, acquired
technology was valued using a risk-adjusted cash flow model, under which future
expected cash flows were discounted taking into account risks related to
existing markets, the technology's life expectancy, future target
<PAGE>   15


markets and potential changes thereto, and the competitive outlook for the
technology. This analysis resulted in an allocation of $2,935,000 to in-process
technology which had not yet reached technological feasibility and had no
alternative future use, and accordingly, was charged to expense, along with an
allocation of $253,000 to capitalized software development costs for technology
in development that had reached technological feasibility, and accordingly, will
be amortized to expense over the estimated useful lives of the technology's
related products.

The following summarized, pro forma results of operations assume the acquisition
took place at the beginning of the respective periods and exclude the $2,935,000
charge for acquired in-process technology.

<TABLE>
<CAPTION>
                                                        Year ended December 31,
                                                     ---------------------------
                                                         1997            1996
                                                     ----------       ----------
                                                      (In thousands, except per
                                                            share amounts)
<S>                                                  <C>              <C>       

Net revenues                                         $   55,018       $   54,534
Net earnings                                         $    5,325       $      506
Basic earnings per share                             $      .40       $      .04
Diluted earnings per share                           $      .40       $      .04
</TABLE>


9. Stock Compensation Plans

At December 31, 1998, the Company has several stock-based compensation plans,
which are described below. The Company applies APB Opinion No. 25 and related
Interpretations in accounting for its plans. As the exercise price of the
Company's employee stock options generally equals the market price of the
underlying stock on the date of grant, no compensation cost has been recognized
for its fixed stock option plans and its stock purchase plan. Pro forma
information regarding net earnings and earnings per share is required by SFAS
No. 123, "Accounting for Stock Based Compensation." Had compensation cost for
such plans been determined consistent with SFAS No. 123, the Company's net
earnings and earnings per share would have been reduced to the pro forma amounts
indicated below:


<TABLE>
<CAPTION>
                                                                     1998             1997              1996
                                                                  ----------       ----------        ----------
                                                                      (In thousands, except per share amounts)

<S>                                     <C>                       <C>              <C>               <C>       
Net earnings (loss)                      As reported              $   10,276       $    3,140        $      396
                                         Pro forma                $    8,585       $    1,516        $     (627)
Basic earnings (loss) per share          As reported              $      .81       $      .24        $      .03
                                         Pro forma                $      .68       $      .12        $     (.05)
Diluted earnings (loss) per share        As reported              $      .78       $      .24        $      .03
                                         Pro forma                $      .65       $      .11        $     (.05)
</TABLE>


For the Company's fixed stock option plans, SFAS No. 123 recognizes compensation
expense for the fair value of each option grant on the date of grant which was
estimated using the Black-Scholes option valuation model with the following
weighted-average assumptions used for grants under each of the option plans in
1998, 1997, and 1996, respectively: dividend yield of zero percent for each
year; expected volatility of 65 percent, 66 percent, and 66 percent; risk-free
interest rates of 5.14 percent, 5.70 percent, and 5.85 percent; and an expected
life of 1.10 years, .84 years, and .82 years.

For the Company's Employee Stock Purchase Plan, SFAS No. 123 recognizes
compensation expense for the fair value of the employees' purchase rights, which
was estimated using the Black-Scholes option valuation model with the following
assumptions for 1998, 1997, and 1996, respectively: dividend yield of zero
percent for each year; expected volatility of 65 percent, 66 percent, and 66
percent; risk-free interest rates of 5.14 percent, 5.70 percent, and 5.85
percent; and an expected life of 0.6 years in each year. The weighted-average
fair value of those purchase rights granted in 1998, 1997, and 1996 was $3.22,
$2.69, and $2.50, respectively.

Fixed Stock Option Plans

The Company has three fixed option plans. Under the 1981 Incentive and
Supplemental Stock Option Plan, the Company may grant options to its employees
for up to 4,095,000 shares of common stock. Under the 1992 Non-Employee
Directors' Stock Option Plan, the Company may grant options to its non-employee
directors for up to 330,000 shares of common stock. Under the 1997 Non-Officer
Stock Option Plan, the Company may grant options to its non-officer employees
for up to 250,000 shares of common stock. Under each plan, the exercise price of
each option equals the market price of the Company's stock on the date of grant,
and an option's maximum term is ten years. Options are generally exercisable in
equal installments over four years.


<PAGE>   16




A summary of the status of the Company's three fixed stock option plans as of
December 31, 1998, 1997, and 1996, and changes during the years ended on those
dates is presented below (shares in thousands):


<TABLE>
<CAPTION>
                                                1998                          1997                          1996
                                         ------------------------      ------------------------     -------------------------
                                                        Weighted-                    Weighted-                      Weighted-
                                                         Average                      Average                       Average
                                                         Exercise                    Exercise                       Exercise
Fixed Options                            Shares           Price        Shares          Price        Shares            Price
-------------                            ------        ----------      ------        ----------     ------         ----------
<S>                                      <C>           <C>             <C>           <C>             <C>           <C>       
Outstanding at beginning of year         1,953         $     8.08      1,452         $     8.18      1,541         $     7.91
Granted                                    447              12.61        845               7.67        486               8.65
Exercised                                 (436)              8.03        (62)              6.61       (240)              6.49
Forfeited                                 (140)             10.14       (282)              9.38       (335)              8.84
                                         -----         ----------      -----         ----------      -----         ----------
Outstanding at end of year               1,824         $     9.04      1,953         $     8.08      1,452         $     8.18
                                         =====                         =====                         =====

Options exercisable at year-end            875                           916                           705
                                         =====                         =====                         =====   

Weighted-average fair value of
options granted during the year                        $     6.22                    $     3.42                    $     4.13
                                                       ==========                    ==========                    ==========
</TABLE>


The following table summarizes information about fixed stock options outstanding
at December 31, 1998 (shares in thousands):


<TABLE>
<CAPTION>
    Range                                     Weighted-Avg.
     Of                    Number               Remaining         Weighted-Avg.          Number           Weighted-Avg.
Exercise Prices         Outstanding          Contractual Life     Exercise Price        Exercisable        Exercise Price
---------------         -----------          ----------------     --------------        -----------        --------------
                                                (in years)

<S>                     <C>                  <C>                   <C>                  <C>                 <C>
 $2.73 to 7.63                547                   6.55                $7.11               299                $7.22
 $7.75 to 8.44                531                   7.91                 8.14               309                 8.11
 $8.50 to 10.13               456                   6.80                 9.63               264                 9.53
$10.50 to 20.00               290                   9.48                13.43                 3                20.00
---------------           -------                -------              -------           -------              -------
 $2.73 to 20.00             1,824                   7.48                $9.04               875                $8.26
===============           =======                =======              =======           =======              =======
</TABLE>


These options will expire if not exercised by specific dates ranging from
February 2001 to November 2008. Prices of options exercised during the
three-year period ended December 31, 1998 ranged from $6.00 to $10.13.

Employee Stock Purchase Plan

Under the 1990 Employee Stock Purchase Plan, the Company is authorized to issue
up to 1,000,000 shares of common stock to its full-time employees, nearly all of
whom are eligible to participate. Under the terms of the Plan, employees can
choose to have up to 15 percent of their annual earnings withheld to purchase
the Company's common stock. The purchase price of the stock is the lower of 85
percent of the market price on either the quarterly purchase dates or the annual
offering date. Under the Plan, the Company sold 108,382 shares, 102,115 shares,
and 106,922 shares to employees in 1998, 1997, and 1996, respectively.

Shareholder Rights Plan

The Company's shareholder rights plan is intended to protect shareholders from
unfair or coercive takeover practices. In accordance with this plan, the Board
of Directors declared a dividend distribution of one Common Stock purchase right
on each outstanding share of its Common Stock held as of May 3, 1991. Each right
entitles the registered holder to purchase from the Company a share of Common
Stock at $90. The rights will not be exercisable until certain events occur. The
rights are redeemable at $.01 by the Company and expire May 3, 2001. As of
December 31, 1998, 100,000 shares of the Company's Preferred Stock have been
reserved for this plan.

10. Common Stock Repurchase

In April 1997, the Board of Directors of Caere authorized the repurchase of up
to 1,000,000 shares of the Company's common stock. As of June 1998, management
completed the repurchase of 1,000,000 shares at prices ranging from $8.21 to
$15.00 per share.

In May 1998, the Board of Directors of Caere authorized the repurchase of up to
an additional 1,000,000 shares of the Company's common stock. As of December
1998, management completed the repurchase of approximately 800,000 shares at
prices ranging from $9.63 to $14.71 per share.

The Company has a net operating loss carryforward for federal purposes at
December 31, 1998, of $11.1 million and federal research and experimentation
credit carryforwards of $441,000. Federal tax laws impose significant
restrictions on the


<PAGE>   17


utilization of net operating loss carryforwards in the event of a shift in the
ownership of the Company, which constitutes an "ownership change" as defined by
Internal Revenue Code Section 382. The acquisition of Calera in December 1994
resulted in such a change. As a result, the Company's federal and California net
operating loss carryforwards are subject to an annual limitation approximating
$2.7 million. Any unused annual limitations may be carried forward to increase
the limitations in subsequent years.

11. Income Taxes

The components of income tax expense (benefit) are as follows:


<TABLE>
<CAPTION>
                                                       Years Ended December 31,
                                              -----------------------------------------
                                               1998              1997            1996
                                              -------          -------          -------
                                                            (In thousands)
<S>                                           <C>              <C>              <C>    
Current:
   Federal                                    $ 2,731          $ 1,109          $   855
   State                                          987              702              250
                                              -------          -------          -------
     Total current                              3,718            1,811            1,105
                                              -------          -------          -------

Deferred:
   Federal                                       (913)            (856)          (1,071)
   State                                          (78)            (135)            (230)
                                              -------          -------          -------
    Total deferred                               (991)            (991)          (1,301)
                                              -------          -------          -------

Charges in lieu of income taxes
associated with the exercise of stock options     698               57              296
                                              -------          -------          -------
                                              $ 3,425          $   877          $   100
                                              =======          =======          =======
</TABLE>

The tax effects of temporary differences that give rise to significant portions
of deferred tax assets and deferred tax liabilities are presented below.


<TABLE>
<CAPTION>
                                                                                  December 31,
                                                                      -----------------------------------
                                                                        1998          1997          1996
                                                                      -------       -------       -------
                                                                                 (In thousands)
<S>                                                                   <C>           <C>           <C>    
Deferred tax assets:
    Federal and state net operating loss and research and
          experimental credit carryforwards                           $ 4,243       $ 5,165       $ 6,671
    State tax expense on temporary differences                            103            24            39
    Accruals for financial statement purposes not taken for
          tax purposes                                                  1,842         1,772         1,333
    Property and equipment principally due to differences in
          depreciation                                                    902           743           373
    Other                                                                  22            39             7
                                                                      -------       -------       -------
         Total gross deferred tax assets                                7,112         7,743         8,423
    Less valuation allowance                                           (2,399)       (3,900)       (5,523)
                                                                      -------       -------       -------
         Net deferred tax assets                                        4,713         3,843         2,900

Deferred tax liabilities:
    Software development costs, principally due to
          capitalization and amortization                                (135)         (256)         (304)
                                                                      -------       -------       -------
         Net deferred tax assets                                      $ 4,578       $ 3,587       $ 2,596
                                                                      =======       =======       =======
</TABLE>


The difference between the effective income tax rate and the U. S. federal
statutory income tax rate is as follows:


<TABLE>
<CAPTION>
                                                     Years Ended December 31,
                                                 ---------------------------------
                                                 1998          1997          1996
                                                 ----          ----          ---- 
<S>                                              <C>           <C>           <C>  
Statutory federal income tax rate                34.0%         34.0%         34.0%
State tax, net of federal benefit                 6.0           9.5           2.0
Utilization of net operating loss
   Carryforward                                  (6.8)        (34.2)       (239.0)
Change in beginning valuation allowance          (6.7)         (9.5)       (206.0)
Benefit of foreign sales corporation             (1.3)         (3.9)        (35.0)
In-process research and development non-
    deductible for tax purposes                    --          25.4         283.0
ZyLAB investment writedown non-deductible
    for tax purposes                               --            --         180.5
Other                                            (0.2)          0.5           0.7
                                                 ----          ----          ---- 
                                                 25.0%         21.8%         20.2%
                                                 ====          ====          ==== 
</TABLE>



<PAGE>   18


The Company has a net operating loss carryforward for federal purposes at
December 31, 1998, of $11.1 million and federal research and experimentation
credit carryforwards of $441,000. Federal tax laws impose significant
restrictions on the utilization of net operating loss carryforwards in the event
of a shift in the ownership of the Company, which constitutes an "ownership
change" as defined by Internal Revenue Code Section 382. The acquisition of
Calera in December 1994 resulted in such a change. As a result, the Company's
federal and California net operating loss carryforwards are subject to an annual
limitation approximating $2.7 million. Any unused annual limitations may be
carried forward to increase the limitations in subsequent years.

12. Earnings per Share

Following is the computation of basic and diluted earnings per share, including
a reconciliation of the shares used to compute basic earnings per share to the
shares used to compute diluted earnings per share. Net earnings is the same for
purposes of computing both basic and diluted earnings per share.


<TABLE>
<CAPTION>
                                                             Years Ended December 31,
                                                         ---------------------------------
                                                           1998         1997         1996
                                                         -------      -------      -------
<S>                                                      <C>          <C>          <C>    
(In thousands, except per share data)   

Net earnings                                             $10,276      $ 3,140      $   396
                                                         =======      =======      =======

Shares used to compute basic earnings per share -
weighted average  common shares outstanding               12,687       13,123       13,120

Effect of dilutive common equivalent shares - stock
options outstanding                                          559          142          199
                                                         -------      -------      -------

Shares used to compute diluted earnings per share         13,246       13,265       13,319
                                                         =======      =======      =======

Basic earnings per share                                 $  0.81      $  0.24      $  0.03
                                                         =======      =======      =======

Diluted earnings per share                               $  0.78      $  0.24      $  0.03
                                                         =======      =======      =======
</TABLE>


For the years ended December 31, 1998, 1997, and 1996, options to purchase
approximately 140,000, 564,000, and 26,000 shares, respectively, of common stock
with exercise prices greater than the average fair market value of the Company's
stock for the period were not included in the calculation because the effect
would have been antidilutive.

13. Segment Information

The Company has adopted the provisions of SFAS No. 131, "Disclosure About
Segments of an Enterprise and Related Information." SFAS No. 131 establishes
standards for the reporting by public business enterprises of information about
operating segments, products and services, geographic areas, and major
customers. The method for determining what information to report is based on the
way management organizes the operating segments within the Company for making
operating decisions and assessing financial performance.

The Company's chief operating decision maker is considered to be the Company's
Chief Executive Officer ("CEO"). The CEO reviews financial information presented
on a consolidated basis accompanied by disaggregated information about revenues
by product type and certain information about geographic regions for purposes of
making operating decisions and assessing financial performance. The consolidated
financial information is identical to the information presented in the
accompanying consolidated statements of operations. Therefore, the Company
operates in a single operating segment: information recognition software and
products.

Net revenue information regarding product type is as follows (in thousands):


<TABLE>
<CAPTION>
                                        1998             1997             1996
                                       -------          -------          -------
<S>                                    <C>              <C>              <C>    
Software products                      $57,351          $47,119          $45,797
Hardware products                        8,451            7,899            8,731
                                       -------          -------          -------
   Consolidated                        $65,802          $55,018          $54,528
                                       =======          =======          =======
</TABLE>


<PAGE>   19

Revenue and asset information regarding operations in the different geographic
regions is as follows (in thousands):


<TABLE>
<CAPTION>
                                  Americas      Europe        Asia     Consolidated
                                  --------      ------        ----     ------------
<S>                               <C>          <C>          <C>          <C>    
Revenues:
   1998                           $44,226      $19,629      $ 1,947      $65,802
   1997                            37,257       16,088        1,673       55,018
   1996                            38,875       13,808        1,845       54,528

Identifiable assets:
   1998                           $61,217      $ 2,667      $    --      $63,884
   1997                            65,793        1,507           --       67,300
</TABLE>


One distributor accounted for 25 percent, 23 percent, and 28 percent of net
revenues in 1998, 1997, and 1996, respectively. At December 31, 1998, this
distributor accounted for 23 percent of trade accounts receivable. A second
customer accounted for 12 percent, six percent, and four percent of net revenues
in 1998, 1997, and 1996, respectively. At December 31, 1998, this distributor
accounted for less than one percent of trade accounts receivable.

The Company has not paid cash dividends on its common stock since its inception.
The Company presently intends to retain earnings for use in its business and
therefore does not anticipate paying any cash dividends in the foreseeable
future. The Company's stock trades on the NASDAQ National Market System under
CAER. On December 31, 1998, there were 349 holders of record of the Company's
common stock.

14. Quarterly Results of Operations (Unaudited)

<TABLE>
<CAPTION>
                                                            1998, Quarter Ended              Year
                                                      ---------------------------------      Ended
                                          Mar 31       Jun 30       Sep 30       Dec 31      Dec 31
                                         -------      -------      -------      -------      -------
<S>                                      <C>          <C>          <C>          <C>          <C>    
(In thousands, except per share data)

Net revenues                             $15,659      $16,168      $15,707      $18,268      $65,802
Gross margin                              12,232       12,285       12,151       14,990       51,658
Earnings before income taxes               2,814        3,187        2,910        4,790       13,701
Net earnings                               2,245        2,393        2,179        3,459       10,276
Basic earnings per share                 $   .17      $   .19      $   .17      $   .28      $   .81
Diluted earnings per share               $   .17      $   .18      $   .17      $   .27      $   .78

Weighted average shares used in per
share calculations:
   Basic                                  13,064       12,817       12,591       12,315       12,687
   Diluted                                13,550       13,531       13,159       12,769       13,246

Common stock price per share:
   High                                  $ 12.50      $ 14.94      $ 14.69      $ 14.00      $ 14.94
   Low                                      8.63        10.06         9.38         8.00         8.00
</TABLE>

The Company has not paid cash dividends on its common stock since its inception.
The Company presently intends to retain earnings for use in its business and
therefore does not anticipate paying any cash dividends in the foreseeable
future. The Company's stock trades on the NASDAQ National Market System. On
December 31, 1998, there were 349 holders of record of the Company's common
stock.


<PAGE>   20

INDEPENDENT AUDITORS' REPORT

The Board of Directors and Stockholders Caere Corporation:
We have audited the accompanying consolidated balance sheets of Caere
Corporation and subsidiaries as of December 31, 1998 and 1997, and the related
consolidated statements of earnings, stockholders' equity, and cash flows for
each of the years in the three-year period ended December 31, 1998. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Caere Corporation
and subsidiaries as of December 31, 1998 and 1997 and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 1998, in conformity with generally accepted accounting
principles.

Mountain View, California
January 22, 1999
KPMG LLP